A few thoughts on EM government debt (2014)

The global financial crisis has not resulted in a general increase in EM government debt, unlike in the advanced economies. EM government debt is generally lower than in advanced economies. After all, empirical evidence suggests that emerging economies tend to suffer from so-called debt intolerance (Reinhart & Rogoff 2003). Estimates as what is a safe level of government debt typically range from 25-40% of GDP for EM, and much higher for advanced economies. Most major EM are in good shape.

Declining sovereign foreign-currency (FCY) mismatches have helped the top-tier EM avoid systemic financial crises in the past ten years. Typically, local-currency (LCY) as opposed to FCY debt affords governments with greater financing flexibility in terms of relying on the central bank as a lender-of-last resort or in terms of raising LCY liquidity through taxation. Moreover, reduced FCY debt makes government debt levels far less susceptible to sharp upward increases in the event of a balance-of-payments shock and currency depreciation.

EM total (public and private) net external debt varies greatly. Sovereign debt crises are often triggered and/ or exacerbated by the existence of contingent liabilities that governments are forced to assume (e.g. banking sector rescue). Today the EM’s total net external debt position is relatively solid. The 2008 crisis has demonstrated this already. Given restrictions on the size of FCY risks the systemically important banking sector can run, the overall FCY position is quite manageable. Combined manageable overall FCY mismatches, EM have little “fear of floating” these days in part due to the sovereign’s ability to provide FCY liquidity to the private sector and in part because “sudden stops” are self-correcting if exchange rates are allowed to depreciate. Tellingly, China and Russia, the two EM with the least flexible currency regimes, run the largest net FCY position.

External financing requirements are overall manageable and much smaller than a decade ago. More sustainable current account positions combined with larger FX reserves has translated into very manageable external financing requirements (EFR). Both the probability and the impact of a sudden stop are significantly smaller than before. Turkey, no question, is the EM most susceptible to a sudden stop. Luckily, the public sector’s net FCY exposure is close to zero, even though its FCY debt as a share of GDP remains relatively substantial at 20% of GDP. An important risk mitigant is a well-hedged banking sector. Thanks to well-hedged sovereign and banking sector balance sheets, Turkey can withstand even significant currency depreciation without running the risk of experiencing a systemic financial crisis as it used to do in the old days (e.g. 2000-01). Large EFR continue to make it susceptible to a sharp economic slowdown in the event of a sudden stop.

Non-resident holdings of EM domestic LCY government debt have increased dramatically. Low US interest rates and reduced EM sovereign FCY issuance have led foreign investors to pile into domestic LCY bonds. While this effectively transfers FCY risk from the issuer to the investor, a large share of foreign domestic bond holdings may nonetheless represent a vulnerability. Foreign holdings have proven quite stable during the 2013 tapering scare. Foreign holdings of domestic bonds are typically concentrated in longer-term, fixed-rate bonds. While this might raise volatility on this part of the interest rate curve in the event of heavy foreign selling, it also limits government refinancing risks. Short-term debt is largely held by residents and they are arguably far more likely to roll-over their debt than foreigners, even in times of market stress.

Government re-financing risks are very manageable. Given solid total external financing requirements and, even more so, the very small share of short-term FCY government debt, FCY refinancing risks have ceased to be an issue for EM. What about overall (basically: LCY) government refinancing risks? It is naturally unfair to compare the financing requirements of advanced economies to those of emerging economies. The former typically benefit from a deep and diverse investor base, often including foreign official investors in addition to a large number of non-bank investors. As far as the EM are concerned, Brazil and India, the two emerging economies with the highest government debt, have the largest gross financing requirements. India benefits from a captive investor base, while Brazil has not experienced liquidity problem with the exception of the 2002 crisis, when the prospect of Lula winning the elections and repudiating debt spooked even domestic investors. Since then, the structure of Brazilian government debt has improved dramatically. A relatively low share of foreign holdings might also be regarded as a mitigating factor in the case of Brazil. Less than 20% of domestic debt securities are in the hand of non-residents investors. In short, liquidity and foreign-currency risks attaching to government debt look quite manageable, even in Brazil and India.

Source: IMF

Cyclically-adjusted primary balances have moved from surplus into deficit over the past few years. Commentary is often focused on this fact. The intuition seems to be that a primary deficit is equivalent to a Ponzi scheme. While in absolute terms debt does increase ad infinitum, the financially relevant metric is the debt-to-GDP ratio. As long as this ratio does not increase indefinitely, government debt is sustainable. What matters therefore is the so-called the interest-rate/ growth differential. 

A favourable interest rate/ growth differential affords most EM to run a primary deficit. The IMF provides estimates of the interest-rate/ growth differentials for the EM. Brazil is the only country with a positive differential due to a combination of high domestic interest rates and low trend growth. Assuming the IMF forecasts are correct, all EM can afford to run (varying degrees!) of primary deficits without seeing their debt-to-GDP ratio indefinitely. In some cases the forecast primary deficit exceeds the interest rate/ growth differential, but the difference is small. 

In the baseline scenario, the adjustment in the CAPB required to stabilise government debt falls within the margin of error (0.1-0.2% of GDP). In the case of Russia, the uncertainty attaching to the CABP forecast is especially significant given the dependence on energy-related revenues. What but if the IMF is too sanguine about the interest rate/ growth differential? This could be the case of if the IMF growth projections are too optimistic and/ or the IMF is too bearish on interest rates. The IMF growth projections appear reasonable. Only Indonesia and Mexico are projected to experience faster growth in 2014-19 than during the boom years of 2002-07. The Brazil projection may appear optimistic. But Brazil should manage to grow 2% a year over the medium-term.

In a downside scenario, government debt dynamics do not appear overwhelmingly unsustainable. If differential moves by 100 bps against the EM, most of them would need to improve their CABP. Brazil, Russia and South Africa would need to make the largest fiscal adjustment in the order of 0.5% of GDP (and sustain it) in order to stabilise debt at current levels. All said, the deterioration of the CAPB should not be too much of a concern assuming (moderate) growth projections and interest-rate projections are more or less correct. Naturally, it would be desirable for the EM to improve their CABPs in order to increase their policy flexibility and widen their fiscal space, including the capacity to react to adverse shocks.

EM government debt would be manageable, even if government were to assume significant banking sector related contingent liabilities. Two words of caution are in order, though. Calculating the CABP is as at least much an art as a science. Moreover, discretionary policy measures can quickly lead to changes in the CABP, while contingent liabilities often materialise rapidly and unexpectedly. Especially the latter can quickly add to the government burden, raise interest rates and interest payments and thereby undermine medium-term solvency, absent a broader fiscal adjustment. In addition to wars, banking sector bail-outs have historically proven a major source of contingent liabilities. Assuming, heroically, that EM governments are forced to recapitalise their banking sectors with funds equivalent to 15% of total bank lending, government debt ratios would increase, but not to an extent where it would irredeemably undermine government solvency. Luckily, EM with large banking sectors tend to have low to medium debt levels and vice versa.

All things considered, government liquidity and solvency risks, including contingent liabilities, appear very manageable in the top-tier EM. The risk arising from contingent liabilities is also manageable. Last but not least, even if EM growth were to underperform and/ or EM interest rates were to rise more than currently expected, the fiscal adjustment required to stabilise the debt-to-GDP ratio looks politically and economically feasible. High nominal/ real GDP growth and limited FCY mismatches, which allow EM to devalue their currencies in order to boost economic growth, would make such an adjustment easier to implement than in economies with a lower growth potential where currency depreciation is not a policy option (e.g. euro area).

China’s rise - trade expectations & naval expansion (2014)

China’s export-oriented industrialisation strategy has proven highly successful in terms of economic growth and development. Economic openness is a critical ingredient of late development. The division of labour allows economies to specialise and take advantage of their respective comparative advantage. Economic openness offers late developers access to advanced technology, even if in the case of China high-technology sales are restricted. From a national and economic security standpoint, however, China’s growing integration and especially a sharply increased dependence on strategic commodity imports have created sensitivities and vulnerabilities. China is the world’s largest exporter of goods. Economically, gross exports overestimate the importance of foreign trade for economic growth, or at least value-added. The value-added may well be less significant that what gross exports to GDP imply. 

Chinese foreign trade as a share of GDP has been declining. Moreover, Chinese foreign trade as a share of GDP is not extremely high, but China’s dependence on commodity imports and its reliance on trade-processing-related job creation over the past few decades alerts makes foreign trade, access to foreign markets and control of sea lines of communication a very important issue. Processing trade is by its very nature very employment intensive. Local value-added has been increased over the past few years and over time, China will become a major source of final demand in its own right. While this will make China more important to other countries and makes political support for a trade embargo less compelling, it will not impact China’s perceived vulnerability significantly. Strategically, the dependence on foreign trade combined with concerns about future access to necessary markets creates considerable incentives to build a navy powerful enough to secure sea lines of communication.

China’s vulnerability to a disruption of international trade is nonetheless significant. Seaborne trade is critical to China’s continued economic development. China is a net commodity importers, 90% of its trade is seaborne as well as 80% of its energy imports, most of which need to pass through the Strait of Malacca. China’s desire to gain control or at the very least be in a position to deter threats to sea lines of communication is eminently understandable. This helps explain significant Chinese efforts to diversify the sources of its commodity and energy exports, including sources that do not depend on seaborne transportation such as Central Asia and Russia. China is becoming increasingly dependent on the imports of natural resources and food stuffs. China is a net manufacturing exporter and a net commodity importer. The dependence is on food and commodity imports is economically and politically more important than a dependence on overseas markets for manufacturing exports. China’s dependence on commodity imports renders it potentially vulnerable, politically and militarily, to outside pressure. It also represents a potential threat to domestic political and economic stability.

Arguably, China’s position is not all that different from Germany’s in the early 1900s and Japan’s in the 1930s. The breakdown of a relatively open world trading system and the emergence of economic blocs was one reason. In an environment where managed trade and political power and domination, the emergence of trade blocs (Ottawa), it is not surprising that aggressive states like Germany and Japan enjoyed significant support among industry. Once again, none of this is to deny that there existed very important qualitative differences between British Commonwealth, Germany’s Lebensraum and Japan’s Greater Asia Co-Prosperity Sphere. In fundamental economic terms, the differences were far less pronounced, if they existed at all. The causes behind Japan’s imperial drive are no doubt complex. Once again, strategic imperative featured nonetheless prominently. Gaining control of resource-rich Manchuria or, under increasing pressure, ensuring access to vitally important natural resource of South-East Asia underpinned Japan’s politico-military expansion, whatever other motives and causes might have played a role. German leaders had good reason to worry about the dependability of outside suppliers. In the decade and a half before the war, dependence on trade for vital goods increased dramatically, driven by phenomenal growth in both population and industrial size. Domestic oil production, for example, had gone up 140 percent from 1900 to 1913, but still accounted for only ten percent of total German oil needs. The state went from being a net exporter of iron ore as late as 1897 to relying on outsiders for close to 30 percent of its needs by 1913, despite domestic production increases of 120 percent. By 1913, over 57 percent of Germany's imports were in the form of raw materials, versus 44 percent in 1903 and 41 percent in 1893. All this was occurring at a time when Germany's ratio of trade to GNP was rising to new heights: from 32 percent in 1900, to 36 percent in 1910, to almost 40 percent in 1913 (Copeland 1996).

Naturally, the factors behind German and Japanese expansionism in the thirties and forties are complex – as are the reasons behind China’s naval modernisation programme. At some level, increasing naval capabilities are simply a reflection of economic growth and bureaucratic interests vying for financial resources. Strategically, however, it shows that rising powers are concerned about their dependence on strategic commodity imports. The breakdown of the international economic and financial system during the inter-war period led Japan to aggressively expand its sphere of economic influence. Its move into South-East Asia was in part driven by concerns about maintaining access to raw material. Similarly, the US oil embargo strengthened the case of the faction supporting the strike against Pearl Harbor.

Strategically, Germany was afraid of encirclement. This is today often derided as a phoney justification for German expansionism. But this is too facile. No doubt, German diplomacy made major mistakes and German Flottenpolitik was one such egregious strategic mistake in that it antagonised Britain and yielded zero military-political return given its inability to effectively challenge the British navy (Kennedy 1976). Imperial Germany had good reason to fear a naval blockade, as wide-spread starvation during the 1917-18 on the back of naval blockade demonstrated. Seeking to improve its imposition by forcing Britain into a naval race was politically and strategically disastrous. But this does not remove the underlying concern. The fact that Japan’s and Germany’s strategies failed disastrously should give Chinese policy-maker reason for pause. After their complete defeat in WWII, the two countries simply had no other option but to rely on the US for foreign market access and the protection of sea lines. The existence of a common enemy and a military alliance provided both countries with reassurance. Last but not least, neither country was in a position to challenge the US. China, by comparison, does have the potential to challenge the US over the longer term as well as locally in the shorter term. China and the US do not face common security threat. It is no surprise that China (Chinese planners and strategists) would be concerned about China’s maritime vulnerabilities.

Source: WTO     *excl. Hong Kong

Washington is strongly committed to the freedom of navigation and interested in maintaining a strong economic foothold in the region, and hence political stability. However, in a conflict situation, all bets might be off. Britain’s naval blockade helped bring Germany to its knees. Geo-politics and geo-economic logic leads China to build a navy. (Germany) Moreover, as China becomes economically more powerful, it will quite naturally seek to strengthen its ability to secure its trade routes. China has a strong interest in staying economically integrated. It also has an interest in mitigating its dependence on strategic commodity imports by diversification or protection. It will therefore be very interesting to see how the shale gas revolution will impact China’s reliance on energy imports. A growing economy and rising per capita incomes will nonetheless translate into significant commodity dependence, at a time when, interestingly, the US may be moving towards greater self-sufficiency. It therefore has a strong interest in mitigating or managing this dependence. Domestic political stability depends on it. China’s economic prosperity depends on it. So do ultimately its international influence and power. Political and military is built on economic prosperity and China’s economic prosperity is heavily dependent on trade and, more specifically, natural resource imports. 

Not surprisingly, China is pursuing a two-pronged strategy of protecting its sea lines of communication and of diversifying its sources of imports geographically, including seaborne and land-based (Central Asia, Russia, Africa). It is equally logical for China’s naval build-up to run head-on into the security interests of many of its neighbours and by extension the US. Military competition, unlike economic competition, if it cannot be avoided is a zero-sum game. From Beijing’s point of view, it makes perfect sense to pursue a strategy aimed at achieving economic security. Following MacMahon, sea power is meant to preserve commercial, political and military aces (in that order). China appears to fit this logic perfectly. China is not building its naval power in order to exert diplomatic and political influence in far-flung corners of the world, but in order to protect its commercial interests. The building of ports Sri Lanka and Pakistan is not as such a naval military strategy, though ports are dual-use, but part and parcel of securing trade routes, commercial access and diversification.

Source: CFR

Paradoxically, China’s naval expansion and territorial-maritime claims is bound to weaken China’s strategic position. Even though China may well succeed in pushing the US navy out of the East and South China Seas, beyond the so-called first island chain, strategically, this would not alter China’s position substantially as far as protecting its sea lines of communication is concerned. If anything, a more assertive Chinese stance will lead most countries in the region to move closer to the US. This is what Edward Luttwak (2012) calls the “logic of strategy”. Virtually all the countries making up the first island chain have an interesting in opposing China’s claims and in countering its strengthening naval capabilities, whether or not they join a formal alliance. As these countries control choke points that China would find it possible break through, China’s naval modernisation will have little to show for in strategic terms. It may help China gain control over its “near maritime abroad” and perhaps the natural resources that fall within the so-called nine-dash line. But this is a heavy price to pay for what no doubt will be perceived by Beijing as a strategic-maritime encirclement. The ghost of Tirpitz may end up haunting China. Germany’s imperial fleet proved pretty much useless in military terms and was extremely costly in diplomatic terms.

Beijing’s geo-political position is not great in the first place. The Philippines, Vietnam, Brunei, Malaysia have competing maritime claims in the South China Sea. Japan and China have competing claims in the East China Sea. Importantly, Myanmar’s decision to open to the outside world seems to be at least in part driven by concerns about becoming overly reliant on China, economically. Moreover, the US has close allies in Japan and Korea, Singapore, Australia and New Zealand, Thailand. India is also pulling closer to the US and naval competition is accelerating with both countries pursuing aircraft carrier programmes. Sino-Russian relations have historically been difficult and the two countries even went to war with each other in the sixties. While Moscow is keen, it is concerned about rising Chinese influence in Russia’s demographically Far East. In spite of energy co-operation, Russia regards China as more of a potential competitor than ally. In short, China has no major ally in the region. Laos and Cambodia are relatively insignificant countries. North Korea is more of a liability than an asset whose main use is to prevent the emergence of a unified Korea allied with the US.

China should therefore strenuously seek to avoid conflict with its neighbours and settle outstanding disagreements through negotiations in order to avoid countervailing alliances. It is far from obvious that the benefit of successfully asserting maritime claims outweighs the costs of antagonising its already suspicious neighbours and driving them into an anti-China alliance out. Beijing’s more assertive behaviour does bring about exactly the opposite. Instead of “speaking softly and carrying a big stick” (Teddy Roosevelt), it does almost the opposite. After all, what looks like aggressive posturing to its neighbours looks like a rational and logical step to reduce its vulnerability or at least raise the costs of imposing a naval blockade on China. This is the nature of a “security dilemma”. 

By contrast, the US has the advantage of being an off-shore balancer. China has territorial and maritime claims. The US has established a track record of relatively free trade and freedom of navigation. China has not. China’s more assertive diplomatic stance risks antagonising its neighbours, while its growing naval capabilities raises concerns. It is not easy being a rising power. This will make it attractive to many countries in the region. As an off-shore balancer and no territorial claims and committed to upholding the freedom of navigation, the US is perceived as less threatening than a rapidly rising, more assertive China. China has relatively few friends and zero allies. North Korea is useful in so far as it helps maintain a buffer between the China and future potentially US-allied, unified Korea. By contrast, China has a volatile friendly in North Korea and has garnered goodwill in Cambodia and Laos.

The risk of outright military conflict may be somewhat mitigated by confidence-building measures and strategic re-assurance, but it is far from obvious that it will suffice to overcome the logic of strategic competition itself. Some analysts have argued that a policy mix of reassurance and resolve may help manage rising security competition (O'Hanlon & Steinberg 2014). More likely than not, such policies may help mitigate competition and help manage some risks associated with (e.g. accidents), but it is unlikely to overcome the underlying logic represented by the security dilemma. China wants project power outwards, leading many of its neighbours to feel threatened. Moreover, the US is also very unlikely to concede East and South-East Asia to China’s sphere of influence. The need to reassure allies has led the Obama administration to pivot to Asia. This is of course not the way Beijing sees it.

China was for a long time focussed on Taiwan. Recently Chinese claims have become more extensive and have been asserted in a more forceful manner. China seems to claim most of the South and East China Sea and its expanding military capabilities are increasingly representing a threat to US naval assets operating in the Taiwan Strait and within the so-called First Island Chain (Japan, Taiwan). Ballistic anti-ship missiles even have the capability of striking US assets beyond the First and potentially second island china (Guam). This threat remains manageable from the US perspective, as China seems to lack the ability to locate and zoom in on a moving target thousands of miles at sea. Moreover, the US navy will have available tactical counter-measures. Nonetheless, China’s naval modernisation has begun to present a threat to the US navy. This contrasts sharply with the unchallenged control of the sea the US navy enjoyed until very recently. The other dimension of China’s naval build-up is to do with Taiwan and China’s long-standing claims to sovereignty there. Using nationalist rhetoric disguises the longer-term strategic objectives China is, consciously or unconsciously, pursuing.

In recent years, China is increasingly making its presence felt in the East and South China Sea. China is actively pursuing a policy of what military strategists call anti-access/ area denial. The US responds by adopting the Air Sea Battle concept that seeks to strike deep on land-based threats. The US seeks to maintain escalation dominance. Military planners are prone to see military relations as a zero-sum game. Strategists have to take into account the political purpose that military might is meant to achieve. It is important to distinguish between military competition and nuclear. A strong case can be made that nuclear weapons are deterrent instruments, much less so, if at all, coercive tool. This is all the more true in the case of two countries possess a nuclear deterrent. The existence of a nuclear deterrent may reduce the risk of an all-out war. This does not mean that military competition or an arms race cannot or is not taking place. The best China can hope to achieve in the short- to medium-term is turn the seas within the first island chain into an area of “mutually assured denial” (Holmes) for itself and its neighbours, including the US.

The risk is that China inadvertently enters into a naval race with the US and thereby antagonises its neighbours fearful of China’s territorial claims and concerned about China’s broader ambitions. A comparison with Imperial Germany seems to suggest itself. Wilhelmine Flottenpolitik did a great deal of damage to British-German relations and ultimately led London to reinforce its presence and meet the challenge head-on. The situation is however somewhat different in the sense that the German navy potentially threatened Britain directly rather than its overseas possessions or allies. Nonetheless, the outcome was relatively predictable. Diplomatically, it was a catastrophe. Militarily, it was a disaster. Famously, the German navy saw very short-lived naval action before retreating to its home port. A military strategy without a political-diplomatic strategy is not helpful and in many cases decidedly harmful. China may run the same risk. Rising naval power is one thing. Rising naval power combined with intensifying territorial and maritime disputes with its neighbours is likely to provoke a strong reaction from its neighbours, who will feel much less threatened by an off-shore balancer like the US than the rising hegemonic power in Asia. It is no coincidence that India is accelerating its naval build-up, including indigenous aircraft carriers. Japan’s launching is to be seen in the same light.

China, inadvertently or not, aims to shift the balance of military power in the surrounding seas in its favour, or at least acquire the ability to turn the seas into a no-go zone for the US and other countries. Its rather extensive maritime claims strongly suggest this. Moreover, the string of pearls strategy aimed at securing trade routes linking China to the region sitting on large, cheap energy, the Middle East, will bring China directly in competition with India. In addition to having unresolved border conflicts, China’s construction of port facilities around India littoral will lead India to respond. The fielding of an indigenous aircraft carrier and naval expansion show how seriously India takes China’s growing presence in the India Ocean and Arab Sea.

Meanwhile, Washington is responding to the perceived rise in Chinese power and capabilities in the political and military sphere by strengthening relations with its regional partners and allies (e.g. Australia, India, Japan) and increasing its military posture in the region, while treading cautiously in areas of more direct concern to Beijing (e.g. Taiwan). The TPP is squarely intended to exclude China by integrating the economies of Washington’s major allies and partner on both sides of the Pacific. No wonder, China feels this is another initiative directed against it.

Henry Kissinger (2011) dedicates the last chapter of this book to a brief comparison of the rise Imperial Germany after 1871 and that of China today. An important question is whether it is China’s intentions or its capabilities matter. It is clear that military planners are predominantly occupied with capabilities rather than intentions. In other words, military planners will tend to be offensive realists. Political leaders may or may not be defensive realists, but they have greater flexibility in terms of their world view. (It is therefore imperative that politician remain firmly in charge and ensure that military strategy remains subservient to a country’s overarching political strategy. After all, war is the continuation of politics by other means, not vice versa. Capabilities matter far more than intentions, at least as long as states have failed to build security communities (Deutsch 1957, Schroeder 2004, Wendt 1992). Socialisation may change things, but socialisation requires a context conducive to creating trust. A common threat or enemy may help alter perceptions more permanently (e.g. France-Germany after 1945) and it may have facilitated agreement or softened competition between Britain and the US post-WWI.

Barring a major accident, Chinese economic power and military capabilities will continue to increase and geopolitical competition in East and South-East Asia is bound to intensify. China’s increasing economic interdependence increases China’s interest in securing its seaborne lines of communication. Its economic rise affords it to expand its naval capabilities. While China remains many years away before it is in a position to reach naval parity, its expanding capabilities, combined with greater assertiveness in terms of maritime claims, have already begun to raise concerns among many of its neighbours as well as the US. China, as the rising power, is a less favourable position than the US as the off-shore balancer with no territorial claims and proven commitment to freedom of navigation. In military terms, China’s increasing capabilities and threat asymmetry will lead to intensifying military and naval competition in East Asia. The existence of nuclear weapons will limit the risk of war, but it does not prevent conventional military competition. Economic and financial interdependence will raise the costs of military conflict, but it will not render it impossible. After all, interdependence did not prevent the outbreak of WWI. It is crucial that political considerations outweigh purely military considerations. This is what distinguishes the responsibilities of the political and military leaderships. Sound strategy makes it absolutely imperative that politics prevails over military necessity. After all, to extend Clausewitz: war (and military competition) is simply the continuation of politics by other means. It was the rise of Athens and the fear that this inspired in Sparta that made war inevitable. The rise of China certainly inspires fear in a number of countries and will lead to military, political and diplomatic competition and instability. War is not inevitable, whatever the rise and decline school may argue (Organiski 1980, Gilpin 1981, Kennedy 1987).

The rise of China and the logic of great power competition (2014)

Graham Allison (2017) has  observed that 11 out of 16 times since 1500 in which a rising power challenged a dominant power, the result was war. It is therefore worth casting light on China’s economic and political rise. After all, China’s re-emergence as the world’s largest economy and, potentially, the world’s most powerful state is bound to lead to significant changes in the global distribution of power. It will significantly affect the patterns of cooperation, competition and conflict in virtually all policy areas.

China has, or is about to replace, the US as the world’s largest economy this year or next – if measured in purchasing power parity terms. This will be the first time since the United States replaced Britain in the early 1870s that the baton of economic supremacy will be passed on. A shift in the distribution of global power seems all but inevitable. Whether the rise of China will only affect the distribution of power within the system, or whether it will transform the system itself remains to be seen. The nature and degree of change is bound to vary across different sub-systems and regimes. Patterns of co-operation, competition and conflict will depend on how dissatisfied with the status quo a rising China will be as well as to what extent the status quo powers are willing to co-opt China by accommodating its interests (Ikenberry 2008). Finally, Chinese interests themselves are not immutable and are bound to change over time. China’s approach to intellectual property rights and foreign investment, for instance, already seems to have shifted as a result of China’s increased innovation potential, desire to protect its own IPRs and rising outward investment.

Source: WTO

China’s economic growth underpins its increasing international power across a wide range of issue areas. At present, China is focussed on sustaining its economic growth and its foreign policy seems to have been mostly geared towards this end. The greater assertiveness that China recently demonstrated with regards to maritime claims arguably constitutes an important shift, however. China’s increasing economic wealth allows it to upgrade its military force, while its increasing economic integration increase its incentive to protect its economic interests and prosperity on which its continued rise depends. Critically, foreign trade, and especially an increasing dependence on commodity imports and the concomitant economic, political and military vulnerability, increases China’s desire to secure its sea lines of communication. China has already begun to seek to improve its military position in the seas surrounding China by expanding its naval capabilities and to change the territorial status quo. Whatever the short-term factors underpinning this development, the ultimate strategic goal is to project naval power further afield in order to secure China’s foreign trade and provide China with the tools to prevent a blockade of its sea-based trade – or at the very least raise the costs faced by potential opponents of doing so. 

Expanding naval capabilities have already led and will continue to lead to rising frictions and outright military competition with many of its maritime neighbours as well as the dominant military power in the region, the United States. More broadly, China’s rise as a regional challenger to US power in East Asia will lead to increasing political competition between China, on the one hand, and a US-led alliance of states weary of China’s increasing power. Political competition will not necessarily undercut intensifying economic interaction between the two sides. Importantly, only because China will not be able to match US military power one for one in the near future and only because an armed conflict between China and the US is not in the interest of either side, this does not mean that there is not going to be any competition, if not necessarily, conflict in maritime East Asia and a little further down the line in South-East Asia and the Indian Ocean, and eventually the Pacific. 

Chinese policies can be interpreted, perhaps even explained, as part of a broader, longer-term strategy. The term strategy is used very loosely here. Strategy is not necessarily a plan worked out in advance by a unified political leadership. Strategy may well be the outcome of bureaucratic politics or the result of competing domestic political interests. While perhaps stretching the meaning of the term, strategy can be defined as the sum of the choices made by a state in response to the varying incentives and constraints it faces in the pursuit of longer-term objectives, namely prosperity and security, regardless of how and why these policies emerge from domestic political processes and conflicts. States face external constraints and incentives. Whatever the domestic political dynamics, to the extent that China is a rising power it will seek to perpetuate its economic rise, both a pre-condition and a consequence of relative security. 

Analysts who are inclined to see China’s rise as problematic typically attribute individual policies to a broader, longer-term malevolent intent and plans (cf. Jervis 1976). This is a mistake, if only because it diminishes our understanding of China’s motives and of the logic of international competition. Only because policy-makers (and analysts) suffer from cognitive biases does not mean that any talk of intentionality is utterly misplaced. But it there is strong reason to believe that China’s rise will resemble the rise of other greater powers and this resemblance can largely be attributed to the operation of system-level logic. States pursue their interests and – in the realm of security – this translates into zero-sum games. Any rising power will want to pursue economic prosperity and physical security – one generally being the pre-condition for the other. The conditions under which China is pursuing these objectives may differ from those faced by a rising Germany in the late 19^th (e.g. absence of nuclear weapons) or a risen  USSR during the second half of the 20^th century (e.g. land vs. maritime competition). But China’s rise will lead to increased, if initially local, security competition. It already has. In short, the belief (or hope?) that China’s rise will not lead to increased competition will prove to be an illusion (Mearsheimer [2001] 2014: chapter 10). 

China is unlikely to engage in expansionary wars and a great power war is highly unlikely due to the existence of nuclear weapons. But China’s rise will lead to increased competition and rising political tensions over the medium- to long-term. It would be a mistake to blame China for this. Individual countries typically find it impossible to disregard the system-level incentives and constraints that tend to compel rising powers to expand their power and declining powers to check the rising power. 

Rising China – peaceful development vs. the logic of great power competition (2014)

Rising powers tend to challenge the status quo. This is hardly surprising. If international regimes and institutions exist, they are likely to reflect the interests of the dominant power or powers that created or modified them over time. Even if the rising power accepts the existing arrangements, it will seek to gain a greater say within them. In other words: sometimes rising powers seek overthrow the existing regime, and sometimes they will seek to modify the balance-of-power while remaining supportive of the basic function and structure of the regime. The degree to which change takes place will vary by issue area and is determined by the ability to resist change by the status quo powers as well as their willingness to accommodate the rising power. The rise of a state to economic supremacy generally proves disruptive.

China is likely to have little interest in changing the main pillars of the international trade and financial regime. After all, it has done rather nicely. But it will want to have greater say within the existing structures and institutions. In other areas, China may seek more fundamental changes (e.g. maritime claims). Many analysts have likened China’s rise to that of the German Empire after 1871 and fully expect China’s rise to be similarly destabilising (Friedberg 2011; Mearsheimer [2001] 2003: chapter 10). Others believe that China, benefitting hugely from the current global system, will become a “responsible shareholder” (Shambaugh 2005; Ikenberry 2008). 

Nonetheless, historical experience suggests that great power transitions give rise to instability, and, historically, more often than not great power war (Gilpin 1981, Kennedy 1987). Power transition theory postulates that “(a)n even distribution of political, economic, and military capabilities between contending groups of states is likely to increase the probability of war; peace is preserved best when there is an imbalance of national capabilities between disadvantaged and advantaged nations; the aggressor will come from a small group of dissatisfied strong countries; and it is the weaker, rather than the stronger; power that is most likely to be the aggressor” (Organski 1958). A weak state or coalition of states is unlikely to directly challenge the dominant power militarily. Knowing that there is little chance of success, weaker states will refrain from challenging the dominant power. Once dominant power and challenger move closer to economic-military parity and it becomes less obvious who would prevail in a direct confrontation. Moreover, the dominant power fearing to lose ground may be led to engage in prevention. 

Economic interdependence risks making military conflict more painful and nuclear weapons would make it potentially more destructive. Certainly, as WWI demonstrated, economic integration is not an absolute barrier to military conflict. It remains to be seen to what extent the existence of nuclear weapons will help prevent a great power war. Accounting for the existence of nuclear weapons, which makes a direct military confrontation unlikely, competition and confrontation does not necessarily take place in the form of military confrontation. More likely, this will play out in diplomatic, economic and political terms against the backdrop of on-going military competition, but not an outright confrontation. The Cold War did end without a clash between the US and the Soviet Union.

Washington is responding to the perceived rise in Chinese power and capabilities in the political and military sphere by strengthening relations with its regional allies (e.g. Australia, India, Japan) and potential partners/ allies (e.g. Malaysia, Philippines, Vietnam) and increasing its military (naval) posture in the region, while treading cautiously in areas of more direct concern to Beijing (e.g. Taiwan). At the same time, Washington is seeking to engage Beijing in the economic sphere, albeit it with limited success thus far (e.g. currency policy). The “responsible shareholder” school foresees, not least because Beijing (in their view) will remain focused on domestic economic development (“peaceful rise”, “peaceful development”) and therefore would be foolish to challenge a political and economic set-up from which it has benefitted tremendously over the past three decades. Sure, recent diplomatic and naval clashes with its neighbours over a variety of maritime claims (Japan, the Philippines, Vietnam) as well as territorial disputes (India) is not exactly helping to mollify China’s neighbours.

Global military expenditure (2014)

Military spending as a share of GDP has declined in all the world’s major economies over the past couple of decades. In 1988, Soviet and US expenditure amounted to 15.8% and 5.7% of GDP, respectively, dramatically higher than today. The US continues to account for more than 40% of total expenditure in nominal dollar terms. Economically, defence expenditure is relatively unproductive. An aircraft carrier may help pursue a country’s national interest or help defend the realm. But it is less economically productive than infrastructure or machinery and equipment. Defence-related government savings contributed to the “peace dividend” of the Clinton years. Today many European countries face significant fiscal pressures against the backdrop of low growth and large deficits. Not surprisingly, defence spending has been declining in recent years. The trade-off between “guns and butter” is likely to intensify, not just in Europe but also in the US and Japan. Ageing populations and rising public pension- and health-care spending pressures will limit the scope for high military expenditure – at least during peace time.

Source: SIFRI

Structural reform in the BRIC – what needs doing? (2013)

Economic growth in the emerging economies, in general, and in the BRIC, in particular, has slowed down significantly, while for now headline inflation remains quite elevated – China excepted. This points to rising supply constraints and suggests that the growth slowdown is in part structural. Labour markets in Brazil and Russia, for instance, are very tight. While all BRIC economies are in need of productivity-enhancing reform, measures necessary to tackle these constraints vary. 

Hausmann et al. have proposed a framework for the identification of the so-called (most) binding constraint(s) limiting economic growth, called growth diagnostics. Cross-country regression analysis may help identify the factors that constrain economic growth, whether they be low human capital, weak institutions or insufficient capital accumulation. Each country faces a unique set of economic, socio-political etc, conditions, however, and cross-country research singles out the factors that on average support higher economic growth. 

The growth diagnostic strategy, on the other hand, seeks to identify the “the most binding constraints on economic activity, and hence the set of policies that, once targeted on these constraints at any point in time, is likely to provide the biggest bang for the reform buck”. More specifically, Hausmann et al. (2008) propose a decision tree that helps identify the causes of low private investment. The underlying assumption is that it is the level of private investment that in large measure determines future output growth. This framework can be heuristically applied to the BRIC economies. 

Brazil undoubtedly suffers from a high cost of finance. This is, however, not due to bad international finance, for external borrowing costs are very low, but due to a combination of low domestic savings and, arguably, poor financial intermediation. Poor intermediation, in turn, can be attributed to banks’ high reserve requirements and a legal framework that makes it difficult for lenders to recover their losses. Raising domestic (public) savings through a longer-term fiscal adjustment should therefore help address the dearth of domestic savings and lessen the need for high reserve requirements. 

China does not suffer from low private investment and the Hausmannian framework does hence not seem to be applicable here. If anything, it would be desirable to reduce domestic savings through greater fiscal outlays and social expenditure as well as, potentially, by raising the cost capital (aka financial and interest-rate reform) and by forcing SOEs to pay dividends to the government. Financial reform would also help boost household income and potentially reduce the propensity to save. This would help wean the economy off potentially excessive investment and all the risks this entails. China could nonetheless introduce reforms aimed at raising the productivity of investment. This would help it maintain high growth in spite of the anticipated reduction in domestic investment and rise in consumption.

Source: IMF

To the extent that India suffers from low private investment, this can be attributed to low social returns. Interest rates have not historically been very high (in real terms) and governance or market failures would appear to be somewhat less important growth constraints as far as low appropriability is concerned than low social returns and, more specifically, a low level of human capital and a bad infrastructure. Illiteracy is very high and the infrastructure is notoriously poor. Admittedly, market failure is likely the second most important binding constraint in India. India should therefore focus on specific bottlenecks in the energy and infrastructure area as well as reduce market inefficiencies (e.g. accelerated approval of large investment projects, land acquisition law, restrictive labour laws).

Last but not least, the relatively low level of private investment in Russia seems to be primarily due to micro-risks and governance failures and ultimately low appropriability. The cost of finance does not appear to be unduly high and Russia has been running current account surpluses for many years, suggesting excess savings. A poor geography and an at best average-quality infrastructure represent important constraints. But compared to the issues of property risk and corruption, these constraints are arguably less “binding”. Structural reforms aimed at boosting private-sector investment will therefore be key to raise medium-term economic growth. A more efficient state would also help boost the productivity of public investment. But state reform is difficult. WTO accession offers a welcome opportunity to implement structural reforms aimed at making the business environment more predictable, strengthen the rule of law and limit corruption. 

Financial position of governments in major advanced economies (2013)

Gross general government debt is the most frequently used measure to compare public debt across countries. The general government sector includes the central, state and local governments, including social security funds. On this measure, Japan has the most highly indebted government in the world among the advanced economies with a debt-to-GDP ratio that is rapidly approaching 250% of GDP. A quite different picture emerges if general government and central bank liabilities are consolidated and assets are netted. This translates into government net financial worth. On this measure, Japanese debt is only 100% of GDP. Net financial worth does not take into account the assets and liabilities of state-owned enterprises nor government equity holdings in publicly-traded companies. Here it worth noting that the gross debt of government-related enterprieses amounts to a mere 13% of GDP in Japan, compared to 52% of GDP in the US. Net financial worth also fails account for non-financial assets owned by the government such as as land, buildings and structures. As of 2010, these were equivalent to 120% of GDP in Japan, compared to 66% of GDP in the US. Last but not least, Japan’s implicit liabilities (aka NPV value of projected increases in pension- healthcare spending during 2011-50 is a mere 34% of GDP, compared to 210% of GDP in the US. The Japanese government’s position does not compare too badly, after all. Naturally, the deterioration of the government’s financial position at the margin (aka fiscal deficits) is of concern and needs to be tackled sooner or later.

Government assets & liabilities (% of GDP)
Source: IMF

Demographic change and government debt sustainability in Brazil (2013)

Brazilian government debt has been declining over the past decade, falling from more than 60% of GDP in 2002 to 35% of GDP today. The current fiscal stance is compatible with a decline of the debt ratio of 1-2 percentage points a year. Gross general government debt, the more widely used indicator for purposes of cross-country comparisons, remains relatively high. But this is to a large extent due to the accumulation of FX reserves by the central bank and sizeable government lending to the state development bank. 

Moreover, even a tangible increase in gross general government debt would be unlikely to cause problems. Assuming, very conservatively, a real interest rate of 7%, real GDP growth of 3%, and taking into account the lower financial return on government assets (mainly FX reserves, loans to BNDES) relative to their financing costs, general government debt could increase by 20-30% of GDP from current levels without jeopardising public-sector solvency. With government debt on a downward trajectory, however, the equilibrium real interest rate is not likely to rise back to its historical average – and each 100bp decline allows the government to reduce its primary surplus by an additional 0.4-0.5% of GDP. 

Over the medium to long term, rising social security and health outlays on the back of aging demographics will put pressure on the evolution of public finances. The combination of a generous social security regime – Brazil spends way more as a share of GDP than other economies with a comparable level of per capita income and is experiencing, at the margin, a more rapid change of its demographic profile – may turn into an increasingly important fiscal challenge over the medium to long term. The net present value of the increase in pension and health-related expenditure exceeds 100% of GDP in Brazil. A rapidly rising (albeit from a low level) old-age dependency ratio combined with generous social security benefits will sooner or later force the government’s hand. 

Source: IMF

Sovereign balance sheets in Brazil and Turkey (2013)

In the early 2000s, both Brazil and Turkey experienced severe financial crises. Currency depreciation and public sector solvency concerns in the context of significant liability dollarisation pushed both countries to the verge of default. Luckily, both countries embarked upon successful IMF-supervised economic adjustment programme under new governments and experienced a decade of solid economic growth. Coincidentally (maybe) both countries have recently been experiencing wide-spread popular protests, albeit for a variety of different reasons. Arguably, the economic stabilisation of the past decade and the emergence of a politically vocal middle class have played a role here. But this is a separate topic. Let’s focus on economics.

The combination of fiscal adjustment and growth acceleration underpinned improving government solvency. In Brazil, net public sector debt has fallen from more than 60% of GDP in 2002 to 35% of GDP today. Gross general government debt - the more widely used indicator for purposes of cross-country comparisons - remains relatively elevated at 69% of GDP. The more limited decline of gross debt is to some extent due to central bank’s sterilised FX intervention and accumulation policy as well as sizeable off-balance financial transactions in the guise of lending to public sector banks. In Turkey, net general government debt has fallen a little faster than in Brazil, decreasing from 70% of GDP in 2002 to less than 30% of GDP today. Gross general government debt has fallen by much more than in Brazil and today stands at around 36% of GDP.

Both sovereigns have successfully reduced their (net) foreign-currency (FCY) exposure. At end-2012, Brazil’s sovereign net FCY creditor position was 14.2% of GDP, compared to Turkey’s 1.7% of GDP. Both countries have largely eliminated domestically-issued FCY(-linked), while a decade ago, 30-40% of domestically-issued government debt in both countries was linked to the exchange rate. In Brazil, the general government domestic debt is 55.8% of GDP, compared to total debt of 58.7% in 2012. By comparison, Turkey’s domestic debt amounts to 28.4% of GDP, compared to a total of 37.6% of GDP. The Brazilian central bank holds FCY assets worth 14% of GDP, roughly the same as in Turkey, translating into net FCY creditor  position in both cases.

A sovereign net FCY creditor position means that, unlike a decade ago, exchange depreciation leads to a decline – rather than a significant rise – in the net debt-to-GDP ratio. Accumulating large FX reserves does come at a direct financial cost, however. First of all, the central bank typically sells government bonds from its portfolio to absorb the additional liquidity created by FX purchases, thus effectively financing lower-yielding FCY-denominated assets by way of higher-yielding local-currency (LCY) government debt. Moreover, to the extent that a currency is undervalued in real terms, reducing net FCY debt deprives the sovereign of the opportunity to reduce the LCY value of FCY liabilities by way of real currency appreciation. Last but not least, the resulting larger stock of domestic LCY debt will tend to help keep domestic interest rates high. 

On the flipside, a large net FCY creditor position (aka large FX reserves) provides the authorities with more ammunition to intervene in the FX market and provide FCY funding to domestic financial institutions and corporates in case of a “sudden shock” (e.g. Brazil in 2008-09). Brazil certainly has a much a more favourable external liquidity position than Turkey. It may be worth noting that the CBRT’s net international FX reserves amount to less than half its reported reserves after adjusting for domestic banks’ FX deposits with the central bank. In practice, this may not make a significant difference, but in this respect Brazil’s position is more favourable, too.

While both the Turkish government and the banking sector can sustain even a large exchange rate shock, limited FCY liquidity means that the impact in terms of higher interest rates, lower local liquidity and economic growth will be much more significant than in Brazil. It is no coincidence that Turkish real GDP declined dramatically in late 2008 and early 2009, while the Brazilian economy only registered a very mild decline in output. Turkey is no doubt more exposed to a sudden stop, and while the government and the banking sector seem well-positioned to withstand significant exchange rate depreciation, the authorities have significantly less scope to soften the impact of such a shock as far as external liquidity is concerned. 

Interestingly, Brazil’s significantly more favourable FCY position does not translate into lower sovereign risk as reflected in CDS spreads. Curiously, as of early July Brazilian 5Y CDS spreads traded at 195 bp versus 180 bps in Turkey. Naturally, Turkey’s gross and, less so, net public sector debt is lower than Brazil’s. But its external position, if not vulnerable, is undoubtedly more sensitive to an external shock than Brazil’s. It looks as if the benefits Brazil derives from a large sovereign FCY creditor position in terms of markets’ perception of sovereign risk are at best very limited compared to Turkey, while it undoubtedly translates into higher (quasi-) fiscal costs. Nominal and real interest rates in Brazil remain significantly higher than in Turkey. That said, large FCY holdings do make Brazil less susceptible to a sudden stop than Turkey. Think of greater quasi-fiscal costs as an insurance premium.

Government debt sustainability in the emerging markets (2013)

Governments in the advanced economies are facing sizeable short-, medium- and long-term debt sustainability challenges. By contrast, government debt in the EM has been trending down due to a combination of solid economic growth, low interest rates and, with only a few exceptions, sustainable fiscal policies. More specifically: gross general government debt is set to remain stable or decline over the next five years, with the possible exception of Russia. But Russia has by far the lowest level of government debt among the top-tier EM and the rise in debt is likely to be negligible. Moreover, if the government’s non-equity financial assets are taken into account, the government is a net creditor. 

If implicit debt is taken into account, a somewhat less straightforward picture begins to emerge. If the implicit debt stemming from the increase in pension- and health-expenditure is taken into account (and adequately discounted), countries like China and Russia, the two countries with the lowest government debt level, begin to compare much less favourably to countries with large public debt burden, like India, but with limited implicit pension- and healthcare liabilities. According to the IMF, the NPV value of spending increases in 2010-50 is in the 200-300% of GDP range for China, Russia, Korea and Turkey, and less than 100% of GDP for India, Mexico, Indonesia and Poland. Naturally, this is not meant to suggest that these liabilities were materialise. Pension and healthcare reforms do take place and fiscal policy can be adjusted to deal with the impending rise in spending and liabilities.

Historically, emerging markets (EM) have tended to get into financial trouble on account of their FCY debt. In addition to a decline in government debt, the share of FCY debt as a share of total debt has fallen in virtually all EM. At the same time, increased FX reserves have substantially reduced – and in many cases – eliminated potentially risky net sovereign FCY exposure of the public sector. The public sectors of most top-tier EM are net FCY creditors. In effect, this means that currency depreciation results in a reduction of net public debt. Many EM have replaced FCY debt owed to foreigners with LCY debt owed to foreigners (thus overcoming the so-called “original sin”).

Source: IMF

Last but not least, while fiscal deficits are quite small, generally less than 3% of GDP (with the significant exception of India), and consistent with stable-to-declining debt-to-GDP ratios over the medium term, gross financing requirements remain large, at least by EM standards. In 2013, they will range from 17% of GDP in Brazil to basically zero in Korea. Both gross and net financing requirements have generally been declining, or at least they have not been increasing, in recent years. In many cases, the maturity structure of domestic debt has improved. Government refinancing risks are very manageable, not least because medium-term debt sustainability and credit risk is generally not an issue. After all, non-resident holdings of government debt in countries with large financing needs are low as a share of GDP – and vice versa. Like in most other EM, sovereign risk is mitigated by manageable underlying debt dynamics, limited-to-non-existent FCY mismatches and the fact that where foreigners make up a significant share of the investor base they tend to hold longer-duration debt.